PFICs: applying the subsidiary look-through rules to intercompany transactions.

• Author: Bowers, Chris
• Position: Passive foreign investment companies

When it comes to the rules governing passive foreign investment companies (PFICs), cruel is not unusual. In making the threshold determination of whether a foreign corporation is a PFIC, taxpayers need not look much farther than the Sec. 1297(c) subsidiary look-through rule to see the truth of this statement.

Background

In general, any U.S. investor (no matter the size of his holdings) in a PFIC is subject to tax at top marginal rates and must pay a special interest charge on the PFIC's earnings, unless he timely elects to currently include in income a pro-rata share of the PFIC's earnings; see Secs. 1291, 1293 and 1296.

A PFIC is any foreign corporation that satisfies either an income or asset test under Sec. 1297. The income test requires that 75% or more of a foreign corporation's gross income must be passive income, which generally means "foreign personal holding company income," defined in Sec. 954(c).

Under Sec. 1297(a)(2), the asset test requires that at least 50% of the foreign corporation's assets (based on either fair market value or, if elected, adjusted tax basis) held during the tax year must be passive assets. Passive assets are assets that produce passive income, or are reasonably expected to produce such income; see Notice 88-22. Both the income and asset tests apply on a gross basis; liabilities do not reduce the amount of income or assets.

Applying the Look-through Rule

The asset and income tests are subject to various look-through rules; see, e.g., Sec. 1297(b)(2)(C). One rule of particular potency is Sec. 1297(c). Under this provision, for purposes of determining whether a foreign corporation is a PFIC, the foreign corporation is deemed to hold its proportionate share of the assets and to receive directly its proportionate share of the income of subsidiaries in which it owns (directly or indirectly) 25% or more of the stock (determined by value). This rule generally benefits taxpayers because it prevents holding companies from being classified as PFICs. However, it leaves several questions unanswered.

Example: Foreign parent FP is a holding company that wholly owns A and B, two foreign subsidiaries. FP's only assets are A and B stock, and its only income is that earned on that stock. A is FP's finance arm, and B operates an active business conducted with unrelated third parties. In January 2002, B borrowed $1,000 from A, issuing a note and using the cash to replace old machinery. In 2002, B earns $200 of operating income from its active business and $25 from short-term investments of its...